A 2011 decision by the Utah State Tax Commission, just released on May 20, is a reminder that a holding company taxpayer may be in the trade or business of managing its investments in other entities that conduct business operations. [Utah Tax Comn., Hearing Decision, Appeal No. 09-3091 (Feb. 10, 2011, released May 20, 2015)]
The Utah State Tax Commission, comfortable that its interpretation of Utah’s statutory definition of business income is consistent with interpretations adopted in other states with similar statutes, maintained its long standing position that a taxpayer’s gain recognized on the disposition of an operating subsidiary is apportionable business income if the interest in the subsidiary was an integral part of the taxpayer’s trade or business.
During the years before 2005, petitioner, an S corporation, held roughly a 45.5 percent ownership interest in "Business 6" (a pass-through entity taxed as a partnership) that, in turn, held an 80 percent interest in "Business 3" (an operating entity also taxed as a partnership). Petitioner included income passed through from Business 3 as apportionable business income on its tax return filings.
In 2005, Business 6 disposed of its entire partnership interest in Business 3. Petitioner did not reinvest its share of the proceeds from the sale into the continuing operations of other entities held by Business 6, but redeemed shares from one shareholder and otherwise made distributions to the remaining shareholders. Petitioner, however, did not include the gain from the sale of Business 3 as business income on its 2005 Utah tax return.
Petitioner argued, to no avail, that it had no trade or business, and the gain, therefore, could not constitute business income. The commission's conclusion to the contrary is that petitioner's "business was to own and manage its interests, including its subsidiaries that held operating entities." The commission observed that petitioner, to carry on this business, retained attorneys and accountants, set up banking relationships for the financial needs of the businesses, made determinations about which entities to acquire, and managed and oversaw negotiations. Petitioner engaged in these activities regularly and continuously.
The commission has consistently found that Utah's UDITPA provisions provide two separate bases to determine if income is business income: the transactional test and the functional test. As set forth in Utah Code Ann. § 59-7-302, the functional test categorizes income from tangible and intangible property as business income if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations.
In cases involving a sale or liquidation of a subsidiary, the commission has applied the functional test to treat gain from such a sale as business income. Even though a sale or liquidation may not reflect the taxpayer's normal trade or business, gain from the sale of assets constitutes business income if the assets themselves were used to generate business income.
Although other jurisdictions interpret similar UDITPA provisions differently, the commission noted that California's interpretation of the business income definition is the same as Utah's, as established by that state's supreme court decision in Hoechst Celanese Corp. v. California Franch. Tax Bd., 22 P.3d 324 (Cal. 2001). That decision fostered a line of case law in California and other states, such as Oregon and Tennessee, that interprets the functional test as requiring a showing that the property sold contributed materially to the taxpayer's production of business income "so that the property becomes interwoven into and inseparable from the taxpayer's business."
In this case, it was uncontested that Business 3 had been producing business income, as claimed by petitioner on its tax returns. Accordingly, the commission found the ownership interest in Business 3 to be integral to petitioner’s trade or business and upheld treatment of the petitioner’s disposition gain as business income.
Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: How does your state determine if an asset is an integral part of a taxpayer's trade or business so that gain recognized when the asset is sold is business income?
Additional discussion of the treatment of gain from the disposition of an ownership interest in a pass-through entity can be found in 1500-2nd T.M., State Taxation of Pass-Through Entities: General Principles.
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